I’m going to start blogging out a longer project I’m working on, one I really want your input for. One thing that I always hear from people across a wide range of the political spectrum is that we need more ‘financial literacy.’ In so much as there are products or practices out there that may be harming consumers, the best way to fight them is to make sure consumers are ‘financially literate.’ This is always something that is easy and good to say. Did you know that since 2003, when the subprime market really took off, April has been Financial Literacy Month? Now you do. But in an age where financial expertise seems so discredited what qualifies someone to be financially literate?

(I’m going to table the serious debate about whether financial literacy is a bad thing, and whether or not we should be, in law professor’s Lauren Willis provocatively titled paper, Against Financial Literacy Education. If we can’t even put our finger on what it is, it doesn’t make sense to be for or against it, much less to give it a lot of agency.)

Gatekeepers

One way to investigate this is to see who the academic gatekeepers are on this body of knowledge and see what they say. If you want to think critically about any subject, one looks for the departments where people with expertise study it, and see where the debates are. And one thing I notice about ‘financial literacy’ is that it doesn’t exist in economics. Or anywhere else.

California has been considering taking its one-semester required course in economics for high school graduation and splitting it with a personal finance class. A panicked high school economics teacher wrote to Greg Mankiw, and he responded on his blog:

I agree with this teacher that this law would be a step in the wrong direction. The legislation is akin to requiring high school biology teachers to spend half their class time on issues of personal health and nutrition. Personal finance is a useful life skill, but students need a more thorough grounding in other basic economic principles than what can be learned in the other half of a single semester course. They need a framework to think about such as topics as market outcomes, price controls, taxes, international trade, environmental regulation, monetary and fiscal policy, and so on. The goal of high school economics should be to produce not just smarter decision makers at a personal level but better informed voters on election day.

(For the David Harvey fans in the audience, please do note that the last sentence makes clear how much of a specific political project Mankiw considers this, akin to hypothetical Marxist English professors talking about “consciousness raising” their students.)

Time students spend in class is a scarce resource, and I’ll leave it up to you to decide whether or not it is a better idea to beat kids over the head with the idea of compounding interest versus getting them to mimic just enough calculus to reproduce the Slutsky equation on a test. But do note that an economist studying ‘personal finance’ is a subject akin to a biologist studying something that is not biology; it’s not within the discipline. I hear this from people within finance and economics PhD programs; one really can’t publish in this topic on personal finance, and since one can’t publish in it is doesn’t get researched. Given we are in an age where everything from voting to marriage to criminology has an economist doing a PhD in it, why is there little to no research in this realm? Some thoughts:

– Economics is more interested in representative households, households that can be aggregated to a macro level. Financial literacy involves dealing too much with heterogenous households to be modeled.
– There’s a normative part of this – how should a person manage their finances? – that the methodology, which studies actions and choices as given and reflecting deep preferences, can’t handle.
– There’s something that reeks of terrible remedial education in the subject, long boring lectures about how to read a paystub, or the gendered “home economics.”
– This isn’t just to single out economics; sociologists are much more likely to be concerned with the way consumption and financing gets embedded and performed within a fields and networks. A lot of that sadly ends up as a kind of David Brooks level of analysis in the broader culture (and I encourage Andrew Seal to continue his project of saving Bourdieu’s Distinction from glib readings!).

Who Fills The Gap?

I want to point out this excellent Mary Kane article in TWI, in which she talked about financial literacy groups and their connections to subprime lenders. What I want to note is the two professors quoted as experts who study consumer finance are professors in Family Studies and Consumer Affairs. They are doing excellent work in the field of financial literacy: but, and this is my high-level read on it that may be wrong, it seems to be something they do in addition to their proper studies and duties in their fields.

As there’s little academic backing, there’s no money for journals, research grants, conferences, the development of theory and expertise that is deployable into policy. That leaves the field wide open to be funded by credit card companies, subprime lenders, and others with a vested interest in certain modes of thought becoming the norm. And for expertise to be filled by people who come from motivational speaking backgrounds, and theory to end up as a mess of common-sense adages and low-level morality plays. The theme of Financial Literacy Month for 2008 was “Financial Responsibility Begins with Me”; why didn’t they call it “caveat emptor”?

Realizing this, Robert Shiller’s call for subsidized financial advice for the working and middle class seems like a good way to go, but the question remains: what would they advise?

29 Responses to Who Owns Financial Literacy?

I think a big problem is that, much of the time, discussions of financial (il)literacy involve variations of the following theme:

People are making dumb decisions that, if they knew better, they wouldn’t make.

That simple statement conflicts with conventional economic thinking (especially in research-oriented academic areas) that builds upon the notion of rational actors making utility-maximizing decisions.

I can imagine the arguments never progressing beyond basic assumptions. Imagine a discussion of the use of payday loans:
– “We observe that people repeatedly use payday loans. Given the enormously high interest/fees, consumers do not fully appreciate how much this type of debt is costing them. Solutions to this problem are either government intervention (in capping interest/fees) or improvements in financial literacy.”

– “The observation that people use payday loans is evidence that they are desirable. Who are we to say to a struggling single mother who needs to fix her car in order to keep her job that it’s not worth ostensibly usurious fees to have access to credit she otherwise would be without.”

Again, the very notion that a substantial segment of the population has a suboptimal level of financial literacy, so much so that they systematically make utility-decreasing decisions, is simply irreconcilable with some very basic tenets of mainstream academic economics.

Andy: my favorite is the idea that evidence of steering towards high fee and interest mortgages/other consumer loans when the consumer would otherwise qualify for a better overall deal is read as the difference between those two costs is less than the ‘search cost’ of finding a better deal. “Sure I got screwed over in the yield-spread premium markup, but I got screwed over less than the ‘cost’ of not getting to watch more television at home with my time off, so I just took the deal.”

To whatever extent there is a person who fits that mold, and it’s a giant country, I’m sure there’s a few among the 400 million people, in this thought _everyone_ fits that mold.

This is an excellent topic that deserves lots of attention. I think the question what to advise is pretty important. Even in spite of the last ten years of awful returns there’s still a lot of triumphalism about investing in risky assets. Brad DeLong is still telling people to load up on stocks. You still see numbers like “10% average stock market return” thrown around (The reality is closer to 4% or 5%. 6% for lucky countries). The conventional wisdom is still based in junk like modern portfolio theory and mean variance optimizers.

People treat the stock market like it’s a timeless entity, as if different asset classes are like different elements in the periodic table (for example). I often read people citing market data going back to 1926. Is that really going to help you predict returns for microcaps 80 years later? (If you actually tried to own the equivalent of microcaps anytime before about 2000 the trading costs would have eaten up your principal.) I can’t think of a dumber example of turning a contingent trend into an immutable law. People need to confront the fact that the stock market is an artifact of social relations between owners, managers, and workers (with some natural resources and technology thrown in). It’s not a machine or a natural phenomenon.

It’s strange how a convenience for rentiers became the cornerstone of middle-class prudence and sobriety.

On the plus side, there’s the new life-cycle investing approach (Zvi Bodie and Larry Kotlikoff are the big names in it). Instead of diversification and rebalancing your stocks and bonds they break it down into flows of income, savings, and consumption. And since you don’t live forever, instead of optimizing your portfolio (in America portfolio optimizes you!) you optimize your consumption: you generally wind up buying a low-cost annuity when you stop working. Basically they give up the fantasy of stock market windfalls in exchange for worry-free security. I can’t figure out what they think a 30 year old is supposed to invest in though.

I don’t think you can table the debate over whether literacy is a good idea but then open the question of who should own it. Looking at the “literacy is bad” research links you posted, it seems to me that these two things are related:
– Predatory habits are considered acceptable because financial literacy is co-opted by predatory institutions (your concern).
– Predatory habits are considered acceptable because financial literacy absolves sellers of responsibility (literay is bad school of thought).
Both of these come from the same assumption: that more education would eliminate predatory practices by behavior modification on the buyer side.

In his book Subprime Solution, Shiller proposes independent government sponsored advisors who would talk through contract details with customers before they sign up to mortgages, credit cards and insurance contracts. I think this would be quite a positive move.

Great column Mike. I have a lot to say on this, but for here and now I’ll keep it limited. I’d like to refer you and the readers to this article from CNN, http://www.cnn.com/2009/LIVING/worklife/08/19/cb.unusual.majors.jobs/index.html, which lists college personal finance as under the field of Family and Consumer Sciences. And that’s the department I teach it for at the University of Arizona.

Finance is a pretty snobby field. They don’t cover things that they refer to as “practitioner”, even though they may be extremely important, like personal finance, how to better estimate the cost of capital for a business project, etc. They also are really averse to anything normative, which makes them far less valuable to society (they’ll do an empirical paper on how managers wipe their buts, but on how managers could better run their business? I don’t know, that’s normative, plus efficient market theory says that managers, who with rare exception don’t have Ph.D. tools, would have already thought of and implemented anything a Ph.D. could think of) . And the gatekeepers at the journals and departments appear to care more about advancing their own power, prestige and preferences than about maximizing value to society, or they just don’t even really think about this.

I definitely think that age and phase of life are important factors in portfolio composition. I think Bodie is often misleading (or mistaken), for example in his text, “Investments”, when he talks about time diversification. I responded recently to a letter of his in “the Economist’s Voice” in this blog post:

Richard, thanks for the reply. Now I’m embarrassed. I’d read your letter but had forgotten that you wrote it (I blame Google Reader for making me dumb!). Frank’s “Choosing the Right Pond” is one of my favorites.

I think Bodie’s worry-free investing has a lot going for it. People in their 50s who have hundreds of thousands in their 401Ks invested in stocks and bonds probably should know the real (inflation-adjusted) life annuity value of their savings. People should know what risk-free consumption they can finance out of their savings as a baseline. My concern about that approach is that those annuities are backed by TIPS. It’s as if buying a life annuity is really just buying extra Social Security credits. Can you really scale up the TIPS market that much? Could everybody invest in riskless assets? This leads to questions about the monetary system that I don’t want to get into, and strange fundamental questions about the nature of savings versus investment.

While I agree with the your point re normativity, there are a staggering number of people who do not understand things like compounding interest. Even something as simple as “how much is this credit card purchase really going to cost” would help a lot of people.

Its interesting that Mankiw sees voters being able to directly connect lessons learned in Econ 101 with real-life policy decisions that they need to vote on. Have you ever met someone who found a way to apply the Skutsky equation to a real-life problem? Mankiw may point to the formal economics education that a number of policymakers have had as evidence that such lessons are useful, but I wonder how much we truly use such knowledge. It seems to me that learning formal economics merely opens up more doors, thereby permitting you to be put in a position where you can actually learn life-lessons. I think of this as the MBA situation, where a number of people don’t find themselves applying the lessons learned in B-School, but acquire an MBA anyway (since it makes for great resume-fodder and leads to me more opportunities, with the MBA acquiring some degree of accomplishment in and of itself).
One option is to adopt a community-schools approach to financial education, whereby parents are given a forum to ask questions and have them clarified. Even one “instructor” would do in spreading awareness and given the beneficial effects that community schools seem to have on students, I expect a similar social effort could translate into more community solidarity in transmitting information. Of course, this doesn’t address the issue of institutionalization of financial education, but my hope is that as more people become aware of the need for such awareness, a greater demand for such services will ensue and people will step up to meet that demand. There’s some econ 101 reasoning that might prove useful!

What John (12:58pm) Said, though in my case the late 1970s, midwestern public high school.

FIFA and Visa teamed up on a Financial Literacy game for the upcoming World Cup. They made DVDs, but the web version (http://financialfootball.com/) is the same thing. You advance the ball by answering questions related to household finance. (No Slutsky needed.)

Ok, I should clarify and expand on my comments on the gatekeepers in academic finance.

Success in academic finance can be achieved in very large part by doing things that don’t take a great deal of high level intelligence, but are very time consuming. So, being driven to work massive hours, having very little of a family or other life, if one at all, is a huge advantage in success (as is great physical endurance, little need for sleep, and the ability to do mechanical and memorization things quickly).

Thus, people who are super ambitions, super driven to succeed and have prestige, money, and power, tend to do well in academic finance (and economics), and they end up holding a lot of the gatekeeper positions.

As a gatekeeper, what helps your advancement, prestige, power, and income? It’s making sure that your area of expertise is a hot highly published and prestigious one. So, there will be a strong tendency to award publication in the area(s) of the gatekeeper, or similar and supportive areas, and deny publication otherwise.

Today, no top finance person’s career depends much, or at all, on personal finance, so there’s not much incentive to allow that to get published. Moreover, academic finance is extremely mathematical and specialized today, and personal finance is little mathematical and very broad (if you want to do it well), so there’s little constituency for it.

There are many wonderful and caring people in academic finance, but it’s extremely hard and dangerous to buck the system. You stop publishing, you stop doing what the gatekeepers consider relevant, and you may not get tenure, or ever advance, or get any raises, you may stay stuck at Montana State, and never get to a “prestige” school, after massive hard work and sacrifice to get your Ph.D.

So it’s a lot to ask to try to change the paradigm, change what’s in the tent, so you often do see a favoritism towards what research is more socially valuable, but within the accepted areas, and models, and paradigms, not in adding a new area, or paradigm even if it is extremely socially beneficial.

Mankiw, argues that a personal finance course is valuable in high school, but not worth pushing out an economics course, or half an economics course.

Here’s a key problem: Throughout the history of this country, as we’ve gotten more advanced, citizens have had to be more and more educated in order to be likely to be highly productive, and smart voters. And we’ve responded over time by providing more and more free education, higher and higher grades, and then high school.

But we’ve been stuck at free school only up to 12th grade high school for about 100 years, while the amount of education/learning necessary to be a highly productive citizen, and smart voter, has increased tremendously. Up to age 18 is just not enough, not unless we want to follow the Republican plan of being far less productive, efficient, and wealthy, and fall behind the other advanced nations.

College has such enormous public benefits (externalities), it should be free, just like high school, and it should also be five years, not four. There is just too much that is of socially high return for citizens to know, like personal finance (if well taught), economics I, economics II, and intermediate, so students learn the well established problems of the pure free market, like externalities, asymmetric information, etc., etc.

It’s 2009, not 1909. Free schooling for all citizens should extend beyond the 12th grade.

Dartmouth has a financial literacy center. Annamaria Lusardi seems to be a reputable scholar who has done a lot of work in this area; she runs the center. It is in conjunction with Wharton and funded by the SSA.

With regards to high school education, many financial concepts should be introduced via the math curriculum starting in elementary school. If more kids leave high school with a basic understanding of risk, it’s a win.

I think that financial literacy is important, but will there be a lot of research potential in financial education? Isn’t there already behavioral research that finds for rules-of-thumb, etc.? Basically, what would you like to see in the Journal of Financial Education?

This is a good question. First, having the professors actually understand personal finance well, so that they can teach it well and give good advice, is the most important thing, rather than coming up with new and improved ideas and understanding to add to the best of what currently exists.

Personal finance is taught very poorly today becasue those who teach it typically understand it very poorly. And to teach personal finance well requires broad understanding of many things, not a deep specialization of some sub-area of super mathematical finance. And super-specialization is predominant among finance professors becasue it allows you to crank out more publications, which is over 95% of advancement and reward.

But there is a lot of improvement that can be made via academic research in even the best current ideas and understanding in personal finance, and this is largely due to finance and econ academics aversion to doing normative work, aversion to work on how an individual can specifically maximize in a messy real world situation, and aversion to working broadly, heavily integrating knowledge from different fields, fields besides math and physics, like psychology, sociology, and law.

What are some specifics? Practical lifetime portfolio strategy can be greatly improved; psychological techniques to improve money management and to handle prestige better, to enjoy it without letting it drive you to highly suboptimal behavior, to feel and enjoy prestige for what you have and what you’ve achieved, which will essentially always be higher than some reference group, and how much you’ve improved, rather than never being satisfied and endangering your finances to get more prestigious goods, better, and relatively easy, software and techniques to monitor and coordinate with family your spending, better teaching, and there’s more.

A big part of the problem with this is that in finance and econ academia at least, teaching and great intuitive high level understanding are are actually valued very little in the field overall, as it’s almost all how many papers have you cranked in respected journals, and that can be done very often, and to a very large extent, with just hard mechanical work and understanding of just a very narrow sliver of the field. So there’s just not much reward for learning personal finance very broadly, intuitively and well so you can give great advice and teach excellently.

I should add the area of personal finance related policy is an area where more research could be very valuable. This intersects with many other fields like economics, finance, and law, things like, what restrictions should there be on lenders to improve consumer well being, what types of products are especially tricky, dangerous, and especially likely to be used irresponsibly and harmfully, what “nudges” would be especially beneficial, what are the best programs, incentives, and regulations to promote positive personal financial behavior (and this is broad and crosses over into many areas, like how to encourage more educational attainment and success, how to improve job performance, how to improve health and safety, how to improve child rearing, etc.)

But having a field of research that coordinates, puts together, and synergizes all of these related things, related to personal finance, from other fields can be very valuable, it can result in a lot of very valuable ideas and policy. We really could use a lot more of this with the extreme specialization currently in academia. We have much less than the societal utility maximizing amount of broad, or broader, academics.

I stumbled on this blog and comments, and found it other-worldly in its detachment from the practice of finance. Apologies if I missed the discussion of how important financial literacy is to banks in their CRA efforts.

Financial literacy. An interesting topic in America today. Apparently last year, there were highly educated, highly compensated bankers who had no clue their balance sheets were stacked to the moon with “toxic assets.” I don’t really understand how the Harvard MBA program can prepare such leaders to operate in such ignorance, but what do I know?

(How is something toxic an “asset?” That’s one thing I’m not clear on. But I’m financially illiterate, like much of America.)

I also don’t understand how tens of thousands of American home buyers agreed to mortgages they could never afford to pay. There are any number of online mortgage calculators that allow the consumer to input their income to see how much mortgage they could afford.

Yes, there was a time not so long ago when the desire to own a $500,000 house on a $50,000 salary would have ended with the mortgage application, but the fact that bankers and mortgage brokers decided to make lots of money handing out bad mortgages doesn’t totally excuse the fact that consumers signed up for loans on houses they could not afford.

Financial literacy, it seems, is hard to separate from our giddy-eyed cultural belief that we are all owed the finest, income be damned.

Mike – what I’d like to see you discuss at some future point is the topic of savings. How can regular Joes save any kind of money for events like college and retirement? Traditional savings accounts actually cost money in the long run, when you compare interest rates to inflation rates. The market is gamed, so that only companies like Goldman Sachs or people who obsessively follow it can (perhaps) succeed. There’s really no real way to save for retirement or college these days – at least that’s how it seems to me. The retired people I know are feeling a whole lot of panic these days and I know college accounts have been trashed, making the American dream of acquiring higher education increasingly out of reach for many middle-class families – especially attendance at a private college. Hard to pay for a $50,000 year of college when the average family income is $50,000 a year.

Take a look at the publications. See their table of contents and who sponsored the publicaitons. It is a VERY questionable relationship from a pure academic standpoint. I think it is a waste of time to expect finance and economics academics to conduct research in this area. If there is a place for it it is likely in economics but I agree they would have a hard time with the heterogenous groups.

There is a need for a serioous look at the billions that have gone into ‘financial literacy’ to determine what works and what does not. One are might be from Schools of Education since so much of it takes place there.